Fixed Income Implications of Presidential Election Result

Viewpoints

November 09, 2016

Last night’s unexpected outcome in the U.S. Presidential and Congressional
elections, and subsequent market reaction, bears remarkable resemblance to June’s
UK referendum on continuing EU membership. The vote against the status quo
and establishment delivered a loud verdict favoring nationalism over globalization.
Similar to the Brexit vote, the initial market reaction led to a sharp decline in risky
assets and bid for safer investments such as U.S. Treasury bonds. However, after
stocks traded down in after-market trading and hit their limit at a decline of 5%,
prices have since rebounded to trade above yesterday’s close, resulting in significant
volatility. Overnight S&P 500 futures traded in a range of over 130 points while the
10-year U.S. Treasury bond yield declined to a low of 1.71%, before rising to 2.09%
(38bp range and largest one day move in four years). Short term rates have also been
volatile as odds of a Fed hike in December declined to as low as 50% and are back
to 80% currently. The response in credit markets has generally been more muted, as
investment grade and high yield corporate spreads have tightened modestly since
yesterday’s close.

Our fundamental outlook for fixed income markets has not changed – we remain
concerned about the excesses building in credit markets and the declining ability
of central banks to lean against worsening fundamentals. That fragile environment
is magnified by the lack of clarity behind Trump’s policies, and we expect to see
increased volatility in the short term as the market digests unknown tax, regulatory,
fiscal and trade impacts until we get further details of prospective policies under
a Trump administration. Thus, we are hesitant to jump to any conclusions based
on one day of trading. The biggest immediate impact to markets is likely to be
international trade and how much of an impact protectionism/tariffs will have
on the USD and overall trade volumes. Domestically, the outcome likely will result in
less regulation, lower corporate taxes and more aggressive fiscal policies/deficits.

More specifically, there are several interesting developments that we will be following:

With the significant backup in Treasury rates, which has been seen mostly in higher breakeven inflation rates,
rather than higher real yields, markets are anticipating higher inflation in the future:

An expansive fiscal policy with greater infrastructure spending is expected to have both positive
inflationary impacts as well as lead to a greater supply of Treasuries to fund larger fiscal deficits.

Protectionism and higher tariffs are also likely to lift inflation.

A decline in the value of the dollar due to new, more restrictive trade policies.

We continue to expect the Fed to hike rates when they meet in December. Chairwoman Yellen’s term ends in
February of 2018, and we expect her to complete her term. However, in the meantime, 2 of 7 seats on the Fed’s
board of governors are vacant, and Trump will likely appoint governors more closely aligned with his stated
views than those of Yellen, potentially making building consensus more difficult.

A Fed more aligned with Trump’s view of the dangers of quantitative easing may make the removal of QE more likely,
or the implementation of additional QE less likely, putting further upward pressure on rates.

Infrastructure spending and other fiscal stimulus measures have long lead times, while the impact of tariffs and trade
restrictions will be felt much more quickly. Even if those two policies ultimately offset each other, the difference in
timing could add to pressure on emerging market countries in the near-term.

Although there remain many unknowns about the future direction of policy and markets, given the moves today, we have made
some modest changes in portfolios, primarily on the relative duration positioning given the large move in rates. In core and
core plus portfolios, we have generally added about 0.13 years in duration, taking us to approximately 0.4 years shorter than the
benchmark. Adds were done across the curve, with some emphasis on the longer end given the significant steepening.
We will continue to look for opportunities to add back duration if rates continue to move higher, and will keep a careful watch on
credit markets for signs of additional stress.